Kevin M raised a point about risk last week in the thread titled “Is Buy-and-Hold Just a Marketing Pitch?” He said: “I'm not particularly enamored with any of the funds in my plan and often thought parking it in a bond or money market option was not risking enough to get a good reward. Obviously through the last few years I'm rethinking that.” In this thread-starter, I am going to try to show how those following the Buy-and-Hold Model (which is of course the dominant model today) look at risk very differently from those following the Valuation-Informed Indexing Model (which I favor).
I view the attitude toward risk that Kevin is describing (he is accurately describing the Buy-and-Hold approach) as exceedingly dangerous. In all other areas of life endeavor, we think of risk as something to be avoided. When it comes to investing, we think of risk as something to be sought out. I believe that this is why we are in an economic crisis today. We have taught millions of middle-class people to seek out risk and the result is that we have collectively taken on so much excessive risk that the losses have become big enough to crater the entire economy. We need to rethink this risk question!
The idea that you sometimes need to be willing to take on risk is of course correct. If you are not willing to take on any risk at all, you will not obtain returns big enough for you to achieve your investment goals. The proper approach, though (in my view!) is not to take on risk just for the sake of taking on risk. The proper approach is to take on risk only when sufficient compensation is provided for taking on the risk to justify the losses that may result. This is the critical step in the analytical process that the Buy-and-Holder fail to take.
The root problem is that Buy-and-Holders treat compensation for taking on stock risk as a static thing. Buy-and-Holders reject the idea that we can know in advance when stocks will provide good returns and when they will provide poor returns. So they use historical averages. Stocks on average provide a return of 6.5 percent real. So on average they provide sufficient compensation to justify taking on considerable risk. If the amount of risk associated with investing in stocks AT A PARTICULAR TIME really could not be known in advance, the entire Buy-and-Hold Model really would make sense. If the best we can know is the compensation for risk provided on average, that’s what we must use as our guide to making allocation decisions and the average compensation for risk provided by stocks is great enough for stocks to come off looking better than any other asset class. So it makes sense if this is so to always go with a high stock allocation.
But why do we believe that it is not possible to know the compensation for risk provided by stocks in particular circumstances? Why can’t we determine each year whether the risk associated with stocks is worth taking on at that particular time?
It turns out that there is no solid reason for believing this. Lots of smart people came to believe it for a time because they came to believe in the Efficient Market Theory. But there was never any hard evidence supporting the Efficient Market Theory. it was an HYPOTHESIS, nothing more. When it was tested in 1981 (by Yale Professor Robert Shiller), it failed the test. We are not bound for all time by any principles that follow from a belief in the Efficient Market Theory. We are free to consider whether the compensation for taking on stock risk is a variable thing, whether there are some times at which the likely return on stocks is great enough to justify the risk involved in investing in them and other times when it is not.
There is only one thing you need to know to perform the assessment -- the extent to which stocks are overvalued or undervalued at the time you are thinking of buying them (the approach I am describing only works with purchases of index funds, the prices of individual stocks are too influenced by the fortunes of the particular companies for valuation assessments to be highly meaningful). A regression analysis of the historical data tells you the extent to which valuations have always affected long-term returns (this does not work in the short-term because investor emotion is the dominant influence on stock prices in the short term and investor emotion is highly unpredictable) in the past. Knowing that, you can form a good assessment of what your return will be in 10 years. Once you know the return you will receive from stocks in 10 years, you can compare it to the return you will receive from super-safe asset classes and determine whether the risk of investing in stocks is at this particular time worth taking on and to what extent it is worth taking on (what your stock allocation should be).
The most dramatic example of the benefit is of course supplied by looking at the time when stocks were the most overpriced they have ever been. In January 2000, the range of possible annualized 10-year stock returns extended from a negative 7 percent to a positive 5 percent (the annualized return is the average return you would receive for each of 10 years running). Treasury Inflation-Protected Securities (TIPS), the safest asset class imaginable, were paying 4 percent real. You had to get an annualized return of considerably more than 4 percent real from stocks to justify taking on the risk of investing in them. But there was only a one in ten chance that stocks would pay more than TIPS over the next 10 years. Stocks were indeed more risky than TIPS. But there was no compensation being paid to investors for taking on this added risk (in fact, there was an equity risk penalty in place at the time). This is a case in which taking on the added risk was a bad idea.
The only objection that I know of that can be raised to the idea of using the historical data to know when the risk of investing in stocks is worth taking on is that we do not have enough data to make definitive pronouncements as to how much compensation is being paid to take on the risk of owning stocks at particular times. There is some weight to this objection. We do not have enough data to answer every possible question, and, even if we did, we do not have a strong enough understanding of how stock investing works to possess perfect knowledge as to how to make use of the data. We need to proceed with caution.
It must be kept in mind, however, that the same objection applies to all strategies recommended under the Buy-and-Hold approach. There are millions of investors investing in stocks today without taking into consideration the compensation for stock risk being paid in particular circumstances. The strategies developed under the Buy-and-Hold Model were developed with use of the same limited data set that was used to develop the Valuation-Informed Indexing Model. The same lack of perfect knowledge applies in both cases. We need to proceed with caution when applying Buy-and-Hold strategies too.
My belief is that we need to open a national debate on these questions. The main point here is that the Buy-and-Hold approach to investing is not the only viable approach. There was once a time when smart people thought that it was not possible to know how much the compensation for taking on stock risk changed from time to time. Today there are a lot of smart people who think it IS possible (this group is still a minority, to be sure). A vigorous debate would help both Buy-and-Holders and Valuation-Informed Indexers better understand their own positions and the positions of those following the other strategy.
I personally believe that Kevin is making a mistake in thinking that taking on more risk always leads to better returns. It could be that I am right, it could be that I am wrong. The only way for us as a society to find out is for us to hold lots of discussions of questions that many had once thought had been settled once and for all during the Buy-and-Hold Era.
If it is really possible to know in advance the compensation you are likely to obtain for taking on stock risk, it is possible for all of us to invest in the future far more effectively than we have ever invested in the past. We can obtain much higher returns at greatly reduced risk. I am excited about the possibility of participating in a national debate aimed at finding out one way or another for sure.